The general ledger is the core of your company’s financial records. These constitute the central “books” of your system, and every transaction flows through the general ledger. These records remain as a permanent track of the history of all financial transactions since day one of the life of your company.
Your accounting system will have a number of subsidiary ledgers (called sub-ledgers) for items such as cash, accounts receivable, and accounts payable. All the entries that are entered (called posted) to these sub-ledgers will transact through the general ledger account. For example, when a credit sale posted in the account receivable sub-ledger turns into cash due to a payment, the transaction will be posted to the general ledger and the two (cash and accounts receivable) sub-ledgers as well.
There are times when items will go directly to the general ledger without any sub-ledger posting. These are primarily capital financial transactions that have no operational sub-ledgers. These may include items such as capital contributions, loan proceeds, loan repayments (principal), and proceeds from sale of assets. These items will be linked to your balance sheet but not to your profit and loss statement.
There are two main issues to understand when setting up the general ledger. One is their linkage to your financial reports, and the other is the establishment of opening balances.
The two primary financial documents of any company are their balance sheet and the profit and loss statement, and both of these are drawn directly from the company’s general ledger. The order of how the numerical balances appear is determined by the chart of accounts, but all entries that are entered will appear. The general ledger accrues the balances that make up the line items on these reports, and the changes are reflected in the profit and loss statement as well.
The opening balances that are established on your general ledgers may not always be zero as you might assume. On the asset side, you will have all tangible assets (the value of all machinery, equipment, and inventory) that is available as well as any cash that has been invested as working capital. On the liability side, you will have any bank (or stockholder) loans that were used, as well as trade credit or lease payments that you may have secured in order to start the company. You will also increase your stockholder equity in the amount you have invested, but not loaned to, the business.
Think of the accounting system as a wheel whose hub is the general ledger (G/L). Feeding the hub information are the spokes of the wheel. These include
These modules are ledgers themselves. We call them sub-ledgers. Each contains the detailed entries of its specific field, such as accounts receivable. The sub-ledgers summarize the entries, then sends the summary up to the general ledger. For example, each day the receivables sub-ledger records all credit sales and payments received. The transactions net together then go up to the G/L to increase or decrease A/R, increase cash and decrease inventory.
We'll always check to be sure that the balance of the sub-ledger exactly equals the account balance for that sub-ledger account in the G/L. If it doesn't, then there's a problem.
Think of the G/L as a sheet of paper on which transactions from all four categories of accounts-assets, liabilities, income, and expenses-are recorded. Some of them flow up from various sub-ledgers, and some are entered directly into the G/L through a general journal entry. An example of such a direct entry would be the payment on a loan.
The same concept of a sheet of paper holds for each sub-ledger that feeds the general ledger. A computerized accounting system works the same way, except that the general ledger and sub-ledgers are computer files instead of sheets of paper. Entries are posted to each and summarized, then the summary is sent up to the G/L for posting.
There are a few (and only a few) things you need to understand in order to make setting up your accounting system easier. They're basic (trust me), and they will probably clear up any confusion you may have had in the past when talking with your CPA or other technical accounting types.
These are the backbone of any accounting system. Understand how debits and credits work and you'll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheet out of balance.
Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error.
Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.
Account Type Debit Credit
Assets Increases Decreases
Liabilities Decreases Increases
Income Decreases Increases
Expenses Increases Decreases
Notice that for every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps the entry in balance. Also notice that debits always go on the left and credits on the right.
Let's take a look at two sample entries and try out these debits and credits:
In the first stage of the example we'll record a credit sale:
Accounts Receivable $1,000
Sales Income $1,000
If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income also had a balance of $1,000.
Now we'll record the collection of the receivable:
Cash $1,000
Accounts Receivable $1,000
Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That's as it should be once the balance is paid. The net result is the same as if we conducted the whole transaction in cash:
Cash $1,000
Sales Income $1,000
Of course, there would probably be a period of time between the recording of the receivable and its collection.
That's it. Accounting doesn't really get much harder. Everything else is just a variation on the same theme. Make sure you understand debits and credits and how they increase and decrease each type of account.
Balance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.
A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.
Simply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.
Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection.
There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.
Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).
Think of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank.
We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.
After the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the difference between assets and liabilities. Hopefully, its positive-assets exceed liabilities and we have a positive owners' equity. In this section we'll put in things like
Another quick reminder: Owners' equity is increased and decreased just like a liability:
Most automated accounting systems require identification of the retained earnings account. Many of them will beep at you if you don't do so.
By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company's owners-that's why it's in the owners' equity section. The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slate against which to track income and expense.
The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners' equity accounts rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.
Think of the balance sheet as today's snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).
Further down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.
A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts, use debits to increase them and credits to decrease them.
If you have several lines of business, you'll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.
Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden for the accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source of income you want to track, create an account for it in the chart of accounts and use it.
Most companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won't vary much from month to month. Typical expense accounts include